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Return, Risk, and the Security Market Line

Chapter Thirteen. Return, Risk, and the Security Market Line. Prepared by Anne Inglis, Ryerson University. Key Concepts and Skills. Know how to calculate expected returns Understand the impact of diversification Understand the systematic risk principle Understand the security market line

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Return, Risk, and the Security Market Line

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  1. Chapter Thirteen Return, Risk, and the Security Market Line Prepared by Anne Inglis, Ryerson University

  2. Key Concepts and Skills • Know how to calculate expected returns • Understand the impact of diversification • Understand the systematic risk principle • Understand the security market line • Understand the risk-return trade-off • Be able to use the Capital Asset Pricing Model

  3. Chapter Outline • Expected Returns and Variances • Portfolios • Announcements, Surprises, and Expected Returns • Risk: Systematic and Unsystematic • Diversification and Portfolio Risk • Systematic Risk and Beta • The Security Market Line • The SML and the Cost of Capital: A Preview • Arbitrage Pricing Theory

  4. Expected Returns 13.1 • Expected returns are based on the probabilities of possible outcomes • In this context, “expected” means average if the process is repeated many times • The “expected” return does not even have to be a possible return

  5. Expected Returns – Example 1 • Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? • State Probability C T • Boom 0.3 0.15 0.25 • Normal 0.5 0.10 0.20 • Recession ??? 0.02 0.01 • RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.9% • RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

  6. Expected Returns – Example 1 continued • This example can also be done in a spreadsheet • Click on the Excel link to see this

  7. Variance and Standard Deviation • Variance and standard deviation still measure the volatility of returns • You can use unequal probabilities for the entire range of possibilities • Weighted average of squared deviations

  8. Variance and Standard Deviation – Example 1 • Consider the previous example. What is the variance and standard deviation for each stock? • Stock C • 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029 •  = .045 • Stock T • 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441 •  = .0863

  9. Variance and Standard Deviation – Example continued • This can also be done in a spreadsheet • Click on the Excel icon to see this

  10. Quick Quiz I • Consider the following information: • State Probability ABC, Inc. • Boom .25 .15 • Normal .50 .08 • Slowdown .15 .04 • Recession .10 -.03 • What is the expected return? • What is the variance? • What is the standard deviation?

  11. Portfolios 13.2 • A portfolio is a collection of assets • An asset’s risk and return is important in how it affects the risk and return of the portfolio • The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

  12. Example: Portfolio Weights • Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? • $2000 of ABC • $3000 of DEF • $4000 of GHI • $6000 of JKL • ABC: 2/15 = .133 • DEF: 3/15 = .2 • GHI: 4/15 = .267 • JKL: 6/15 = .4

  13. Portfolio Expected Returns • The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio • You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

  14. Example: Expected Portfolio Returns • Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio? • ABC: 19.65% • DEF: 8.96% • GHI: 9.67% • JKL: 8.13% • E(RP) = .133(19.65) + .2(8.96) + .267(9.67) + .4(8.13) = 10.24% • Click the Excel icon for an example

  15. Portfolio Variance • Compute the portfolio return for each state:RP = w1R1 + w2R2 + … + wmRm • Compute the expected portfolio return using the same formula as for an individual asset • Compute the portfolio variance and standard deviation using the same formulas as for an individual asset

  16. Example: Portfolio Variance • Consider the following information • Invest 50% of your money in Asset A • State Probability A B • Boom .5 70% 10% • Bust .5 -20% 30% • What is the expected return and standard deviation for each asset? • What is the expected return and standard deviation for the portfolio? Portfolio 40% 10%

  17. Portfolio Variance Example continued • This can also be done in a spreadsheet • Click on the Excel icon to see this

  18. Another Way to Calculate Portfolio Variance • Portfolio variance can also be calculated using the following formula:

  19. Figure 13.1 – Different Correlation Coefficients

  20. Figure 13.1 – Different Correlation Coefficients

  21. Figure 13.1 – Different Correlation Coefficients

  22. Figure 13.2 – Graphs of Possible Relationships Between Two Stocks

  23. Diversification • There are benefits to diversification whenever the correlation between two stocks is less than perfect (p < 1.0) • Figure 13.4

  24. Terminology • Feasible set (also called the opportunity set) – the curve that comprises all of the possible portfolio combinations • Efficient set – the portion of the feasible set that only includes the efficient portfolio (where the maximum return is achieved for a given level of risk, or where the minimum risk is accepted for a given level of return) • Minimum Variance Portfolio – the possible portfolio with the least amount of risk

  25. Quick Quiz II • Consider the following information • State Probability X Z • Boom .25 15% 10% • Normal .60 10% 9% • Recession .15 5% 10% • What is the expected return and standard deviation for a portfolio with an investment of $6000 in asset X and $4000 in asset Y?

  26. Expected versus Unexpected Returns 13.3 • Realized returns are generally not equal to expected returns • There is the expected component and the unexpected component • At any point in time, the unexpected return can be either positive or negative • Over time, the average of the unexpected component is zero

  27. Announcements and News • Announcements and news contain both an expected component and a surprise component • It is the surprise component that affects a stock’s price and therefore its return • This is very obvious when we watch how stock prices move when an unexpected announcement is made or earnings are different than anticipated

  28. Efficient Markets • Efficient markets are a result of investors trading on the unexpected portion of announcements • The easier it is to trade on surprises, the more efficient markets should be • Efficient markets involve random price changes because we cannot predict surprises

  29. Systematic Risk 13.4 • Risk factors that affect a large number of assets • Also known as non-diversifiable risk or market risk • Includes such things as changes in GDP, inflation, interest rates, etc.

  30. Unsystematic Risk • Risk factors that affect a limited number of assets • Also known as unique risk and asset-specific risk • Includes such things as labor strikes, shortages, etc.

  31. Returns • Total Return = expected return + unexpected return • Unexpected return = systematic portion + unsystematic portion • Therefore, total return can be expressed as follows: • Total Return = expected return + systematic portion + unsystematic portion

  32. Diversification 13.5 • Portfolio diversification is the investment in several different asset classes or sectors • Diversification is not just holding a lot of assets • For example, if you own 50 internet stocks, you are not diversified • However, if you own 50 stocks that span 20 different industries, then you are diversified

  33. Table 13.8 – Portfolio Diversification

  34. The Principle of Diversification • Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns • This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another • However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

  35. Figure 13.6 – Portfolio Diversification

  36. Diversifiable (Unsystematic) Risk • The risk that can be eliminated by combining assets into a portfolio • Synonymous with unsystematic, unique or asset-specific risk • If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away • The market will not compensate investors for assuming unnecessary risk

  37. Total Risk • Total risk = systematic risk + unsystematic risk • The standard deviation of returns is a measure of total risk • For well diversified portfolios, unsystematic risk is very small • Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk

  38. Systematic Risk Principle 13.6 • There is a reward for bearing risk • There is not a reward for bearing risk unnecessarily • The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away

  39. Measuring Systematic Risk • How do we measure systematic risk? • We use the beta coefficient to measure systematic risk • What does beta tell us? • A beta of 1 implies the asset has the same systematic risk as the overall market • A beta < 1 implies the asset has less systematic risk than the overall market • A beta > 1 implies the asset has more systematic risk than the overall market

  40. Figure 13.7 – High and Low Betas

  41. Table 13.10 – Beta Coefficients for Selected Companies

  42. Total versus Systematic Risk • Consider the following information: Standard Deviation Beta • Security C 20% 1.25 • Security K 30% 0.95 • Which security has more total risk? • Which security has more systematic risk? • Which security should have the higher expected return?

  43. Work the Web Example • Many sites provide betas for companies • Yahoo Finance provides beta, plus a lot of other information under its profile link • Click on the web surfer to go to Yahoo Finance • Enter a ticker symbol and get a basic quote • Click on profile

  44. Example: Portfolio Betas • Consider the previous example with the following four securities • Security Weight Beta • ABC .133 3.69 • DEF .2 0.64 • GHI .267 1.64 • JKL .4 1.79 • What is the portfolio beta? • .133(3.69) + .2(.64) + .267(1.64) + .4(1.79) = 1.773

  45. Beta and the Risk Premium 13.7 • Remember that the risk premium = expected return – risk-free rate • The higher the beta, the greater the risk premium should be • Can we define the relationship between the risk premium and beta so that we can estimate the expected return? • YES!

  46. Figure 13.8A – Portfolio Expected Returns and Betas Rf

  47. Reward-to-Risk Ratio: Definition and Example • The reward-to-risk ratio is the slope of the line illustrated in the previous example • Slope = (E(RA) – Rf) / (A – 0) • Reward-to-risk ratio for previous example = (20 – 8) / (1.6 – 0) = 7.5 • What if an asset has a reward-to-risk ratio of 8 (implying that the asset plots above the line)? • What if an asset has a reward-to-risk ratio of 7 (implying that the asset plots below the line)?

  48. Market Equilibrium • In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal the reward-to-risk ratio for the market

  49. Security Market Line • The security market line (SML) is the representation of market equilibrium • The slope of the SML is the reward-to-risk ratio: (E(RM) – Rf) / M • But since the beta for the market is ALWAYS equal to one, the slope can be rewritten • Slope = E(RM) – Rf = market risk premium

  50. Figure 13.11 – Security Market Line

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